In late 2000, American International Group (AIG), one of the largest insurance companies in the world, struck an intentionally fraudulent deal with General Re Corporation, a Berkshire Hathaway company, so that AIG could add $500 million in reserves to its balance sheet for the last quarter of 2000 and first of 2001. In a plot conspired by multiple top executives, including AIG’s then CEO Maurice Greenberg, General Re purchased reinsurance from AIG to cover some of Gen Re’s insurance contracts. AIG treated the $500 million in acquired premiums as revenue, adding $500 million to its reserves, thus satisfying critics of AIG’s low reserves balance. The individuals involved created phony documents to help support the false AIG accounting entries, which essentially falsely inflated the company’s value by approximately $100 million since 2000.1
The fraudulent transaction came to light in 2004 as part of a continuing investigation into the insurance industry’s accounting practices, during which the Attorney General’s office and NY Insurance Department began looking more closely into AIG. The SEC had previously expressed curiosity in AIG’s business practices, in particular, the SEC was troubled by a product called “loss mitigation insurance” which AIG advertised to corporations through a brochure. The SEC brought litigation against AIG and several companies they believed AIG helped disguise losses in their financial statements. All of these trials were settled out of court. The investigation then turned to whether AIG had manipulated its own financial statements , which brought to light the shady accounting of the reinsurance transaction, as well as several off shore entities practically owned by AIG. According to one critic,
It’s been an open secret for years on Wall Street that no one outside the company really understood its accounting. AIG has long been called ‘opaque’ on Wall Street, which is what analysts say when they can’t figure out a company’s books because much of the detail is off the books.2
The SEC, in conjunction with the U.S. Department of Justice, New York Attorney General, and New York State Department of Insurance, again filed litigation against AIG shortly thereafter.
In the 2005 court proceedings, General Re executives admitted they knew ahead of time that AIG would plan to use a reinsurance transaction to increase its loss reserves, as AIG had been under scrutiny by analysts because of the low balance in their reserves. Many AIG executives admitted the transaction should have been classified as a loan, not as insurance. A crucial grey area here, which the Sarbanes-Oxley Act does not truly address, is how reinsurance should be categorized. As reinsurance is usually a loan, should it be classified as debt? Insurance companies such as AIG traditionally use reinsurance to protect themselves from risk. Reinsurance involves one company, AIG, ordering insurance from another company, Gen Re, to cover an insurance policy they wrote to a customer [insurance for insurance]. In particular AIG has been criticized for wrongly categorizing the finite insurance they purchased from Gen Re. Finite insurance, in essence, distributes the cost of a large insurance policy over several years. In the event that AIG is forced to pay a claim to its customer during the first few years of the policy being in effect, they would file a claim with Gen Re. During this short time period AIG is paying Gen Re a large premium, in effect paying the cost of the insurance policy it granted to its customer over several years. If no claims are made, most of the premium AIG paid is returned to AIG. Accounting standards in this area are open to interpretation,
…there is a question about the accounting for finite policies. ‘Whether it’s an attempt to trick people or not depends on how you are using it,’ Shore notes. ‘The question is: To what extent is this not insurance? To get paid a dollar today in exchange for a dollar tomorrow … that’s not insurance.’3
The real red flag here, is that the reinsurance roles were switched in this case. AIG paid Gen Re $5 million to move $500 million of insurance contracts and their corresponding $500 million worth of premiums to AIG. Then, AIG claimed their cash reserves increased by $500 million, where in essence they had actually taken out a loan. If no claims were made to Gen Re within the specified time period, AIG would return the majority of the $500 million, hence why most accountants would classify this transaction as a loan. The grey area here is that for this cash movement to be considered insurance, some risk has to be transferred between the insuree and insurer. The common thought in this scenario is that risk was not transferred and thus the $500 million should be classified as a loan, thus increasing AIG’s liabilities. The intent of the Sarbanes-Oxley Act is to prevent companies from hiding losses or reporting unearned revenue, in this aspect AIG adhered to the Sarbanes-Oxley Act perfectly,
Early in January, auditors reported that they had finished a yearlong effort analyzing A.I.G.’s internal controls as required under the Sarbanes-Oxley Act, the tough securities law adopted in the wake of the Enron and WorldCom collapses. A.I.G. scored quite high, the auditors proudly reported.4
As a result of the investigation, AIG restated five year’s worth of financial reports, lowering its net income by 10%. In February 2006, the SEC filed an enforcement action against four Gen Re (former) employees and one AIG employee, finding that they violated anti fraud and other federal securities laws. Final settlements call for AIG to pay $1.64 billion toward a combination of shareholder lawsuits, SEC-monitored funds for investor payments, and underpayment of workers’ compensation premium taxes in all 50 states.
Sarbanes-Oxley Act of 2002: Potential Effects
The Sarbanes-Oxley Act of 2002, had it been in place at the time of the 2000 and 2001 fraudulent events by AIG and Gen Re, may have helped prevent it from happening in the first place. One of the act’s primary goals is to enforce auditor independence and require companies like AIG to have their own independent audit committees to monitor the company interaction with it auditor. Had these and other more strict internal controls been in place, both AIG’s own self-monitoring and their auditor, PricewaterhouseCooper (PwC) LLP’s, would have raised the red flag and possibly prohibited AIG from classifying the $500 million as revenue.
In fact, after the AIG fraud came to light, investigation into PwC revealed that it had been dishonest in its long-time auditing relationship with AIG, and that PwC had knowingly ignored warning signs and “red flags” regarding AIG’s poor accounting methods. The audit committee of AIG’s own board of directors repeatedly insisted it could not verify AIG’s accounting methods. In a 2005 Washington Post article, the effects of the Sarbanes-Oxley Act on responsibility was emphasized. According to a spokesman for PwC, prior to the Sarbanes-Oxley Act,
Auditors would not have seen this as a ‘red flag’ or a scope limitation, as the board’s proxy language simply described what was and what was not the responsibility of its audit committee at that time. Auditors also would not have been surprised to see that descriptive language changed after the passage of the Sarbanes-Oxley Act in 2002. The act was designed to make executives responsible for their companies’ accounting.5
Among the other impacts the Sarbanes-Oxley Act could have had on the AIG/Gen Re scam is a potential fear factor that might have prohibited executives from getting involved in the first place. Under the Act, the penalties—both monetary and in terms of jail time—are much harsher than they once were for executives who knowingly commit fraud by misstating financial statements. In the SEC investigation of the Gen Re and AIG executives who concocted the plan, the fraud was treated lightly, and even joked about on recorded phone lines, as if there were to be no consequences. In testimony, former Gen Re executive John Houldsworth’s phone records were revealed. Houldsworth, who pleaded guilty to criminal charges of misstating AIG’s finances, was recorded as laughing about the scam: “They’ll find ways to cook the books, won’t they?” he said to CFO Elizabeth Monrad.6 She was reported to joke back. Had the Sarbanes-Oxley Act been in place, the risk on consequences for committing fraud may have been no joking matter.
One of the issues here with how the Sarbanes-Oxley Act applies to AIG & Gen Re is that the Sarbanes-Oxley Act’s main purpose was to prevent companies from using loopholes and hiding their activities. At AIG and Gen Re, high-level executives conspired to miscategorize insurance as revenue. AIG intended to commit fraud, planned how to cover the fraud, committed the fraud, and then put into action their cover up plan. No act, no matter how strict, can force someone to tell the truth and to play the game fairly.